Thursday, January 7, 2010

This post is a follow-up to a post of mine last month, and to a recent post by Mark Perry questioning whether it is reasonable to expect a pickup in inflation given the big slowdown in M2 growth over the past year. The short answer to his question is yes, it is reasonable to expect inflation to pick up despite the big slowdown in M2 growth. Indeed, an inflation pickup is made more likely by the fact that M2 growth has slowed sharply, after rising sharply in late 2008.

To begin with, the chart above tells us two things: 1) the connection between M2 and inflation is not always consistent, and 2) M2 growth and inflation often (but not always) move in different directions, contrary to what a standard monetarist framework might predict (e.g., faster money growth should lead to more inflation according to standard monetary theory).

For example: Consider the huge pickup in M2 growth from 1970 to 1972, followed by a significant slowdown in inflation from 1972 to 1974. M2 then decelerated sharply in late 1973, only to be followed by a huge pickup in inflation in 1974-75. M2 decelerated in 1978, and was followed by surging inflation in 1979-80. On a more modest scale, M2 decelerated sharply in 2003, and was followed by rising inflation in 2004-5.

The explanation for this, I believe, can be found in the confusing nature of M2. We've all been taught over the years that M2 is arguably the best measure of money supply. I would argue instead that it is one of the best measures of money demand. After all, the Fed only supplies reserves and currency to the world, and currency makes up only 10% of M2. The other 90% of M2 exists because people want to hold money in the form of checking accounts (10%), retail money market funds (10%), small time deposits (13%), and savings deposits (57%).

This distinction—whether M2 represents money demand or money supply—makes a world of difference. When M2 growth slows sharply, I think it usually means that money demand has collapsed; people want less money, so they take it out of their savings account and spend it. That's equivalent to saying that the velocity of money has turned up. Rising money velocity means that a given amount of money can support a greater volume of transactions and/or a higher price level. This follows from the classic equation M*V = P*T.

What we have seen over the past 18 months is this: in Sept. '08 the Lehman bankruptcy sparked a global panic over the imminent collapse of the banking system; this in turn caused money demand to surge as a precautionary measure; rising money demand showed up in a big increase in M2; rising money demand meant a huge decline in money velocity, and that is what caused spending to plunge, economies and industries to shut down, and inflation to fall. Since late March we have been on the positive side of this process: confidence has returned, money demand has declined, M2 growth has slowed to a crawl, the economy has picked up, and inflation has picked up.

I think it is reasonable to expect this process to continue, especially given the 1-2 year lags that we see in this chart. Plus, the inflationary potential of falling money demand is likely to be boosted by the Fed's willingness to keep interest rates very low for an extended period. The evidence of the commodities market and the gold market tells us that people already are actively trying to reduce their money balances in favor of more exposure to commodities and hard assets. And the dollar has fallen very close to its lowest levels ever; dollar demand is clearly weak.

Let me be quick to add that I don't see the seeds of a huge increase in inflation (yet). But I think there's enough monetary fuel out there to push inflation higher over the next year, to 3-4% or more. That might not sound like a lot, but it's above the upper limit of the Fed's 2% target, and it's a lot more than the bond market and the Fed are currently expecting. And that can make for very interesting markets.

13 comments:

And you know why? because inflation is NOT the function of quantity of money but a function of real supply vs real demand. Once people arrive at this simple conclusion taught in basic economics books then the whole world suddenly becomes crisp and clear. And then you start to understand why outsourcing is so dangerous to domestic economy as well as many other issues.

The whole theory of quantity of money is complete non-sense indoctrinated by clowns from Chicago

Don't you think Core CPI has truly become a meaningless to statistic to guage inflation?

Between 2000 and 2006, Housing costs skyrocketed, health insurance costs more than doubled, property taxes exploded, food and fuel prices generally increased yet core CPI was about flat.....and for the most part M2 declined.

I see a 3yr-5yr lag in M2 vs. CPI. Psychology is also a function of individual spending behavior. It takes about 3yrs for individuals to incorporate inflation trends and is the reason why Volcker had to drive rates up 2x in the early '80's as the first attempt had not convinced individuals that he was serious in controlling inflation psychology. Once society understood this, inflation fell like a stone.

Money supply is IRRELEVANT for inflation. Goods supply versus goods demand is the only thing which defines whether the price is going up, down or stays where it is. However this simple fact from most basic economics textbooks is very conveniently ignored by the Quantity Theory of Money in favor of some arbitrary, intractable and unmeasurable stuff called money velocity and inflation expectations. Good luck with self-reconciling all pseudo-PhDs written on these topics

I second septizoniom's question: what do you use as a measure of money supply.I try to view the value of money as a balance between money supply and money demand. Gold is the best measure I know of.If M2 is a proxy for demand (which i can accept) is the Fed's reserve credit or balance sheet a proxy for supply?

To be honest, I don't what the best measure of money supply is. But in any event, it's not really necessary. You can tell what supply is doing relative to demand by watching gold, the dollar, the yield curve, etc.

Well, I am just a guy who makes furniture, and dabbles in economics. But inflation?

Everything is cheaper than five years ago, at least in Los Angeles.

Rents, wages, equipment, All down.

A clever fellow buying used equipment could set up a cabinet shop and run it for 50 cents on the dollar compared with three years ago.

4 percent inflation? Well, maybe, but because we are measuring off of a very soft bottom? If industrial rents in L.A. rise four percent in one year, that will be off of a bottom down 30-50 percent from the very peak.

Anyway, given the incredible inability of either political party to balance the federal budget, maybe we "need" to run 5 percent inflation.

How else to pay off the federal debt?

We spend $18,000 per year, every year, per agriculture employee in crop subsidies. When you drive by a farm and see a fieldhand making, oh, say, $20,000 a year, give yourself a pat on thw back. If you pay federal income taxes, you paid for $18k of that $20k in wages.

This situation will continue in perpetuity.

I am the only person in history ever to compute federal subsidies per worker in the ag sector. That will tell you how uninterested either wing of the current political system is in balancing the federal budget.

Benjamin, lets skip the issue whether money is spent productively or not and let me ask you the following question. Why do you think government debt should be ever repaid? Why do not you treat it as annuity forever and interest payments as a special way to boost aggregate demand? Who needs this debt to be repaid? Pension and insurance companies?! And what will they do with this money? Look for another long-term and safe investment? Where are those?

The concept of core inflation has limited usefulness because it treats energy prices and food prices as exogenous variables - as if OPEC set the oil price in a smoke-filled room in Riyadh with no reference to economic policy in the US.

Another issue is inflation in the prices of goods and services vs inflation in the price of assets.

A third issue is how we measure inflation in, for example, the cost of public schooling. Are spending increases increases in quantity of educational services or are they increases in price. In other words is a state-mandated reduction in class size inflation or is it a quality improvement.

Fourth, how do we take into account inflation in countries with a currency tied to the dollar?

It seems to me that globalization is creating huge swings in relative prices that mask the true rate of inflation when we try to measure inflation in a narrow segment of the dollar-based economy.

Most people in the US believe that costs in the 00s were rising faster than their wage incomes and I believe that to be the case.